Portfolio Theory 2

7
Portfolio Theory
Question 1
Write short note on Factors affecting investment decisions in portfolio management.
Answer
Factors affecting Investment Decisions in Portfolio Management
(i) Objectives of investment portfolio: There can be many objectives of making an
investment. The manager of a provident fund portfolio has to look for security (low risk)
and may be satisfied with none too higher return. An aggressive investment company
may, however, be willing to take a high risk in order to have high capital appreciation.
(ii) Selection of investment
(a) What types of securities to buy or invest in? There is a wide variety of investments
opportunities available i.e. debentures, convertible bonds, preference shares, equity
shares, government securities and bonds, income units, capital units etc.
(b) What should be the proportion of investment in fixed interest/dividend securities and
variable interest/dividend bearing securities?
(c) In case investments are to be made in the shares or debentures of companies,
which particular industries show potential of growth?
(d) Once industries with high growth potential have been identified, the next step is to
select the particular companies, in whose shares or securities investments are to be
made.
(iii) Timing of purchase: At what price the share is acquired for the portfolio depends
entirely on the timing decision. It is obvious if a person wishes to make any gains, he
should “buy cheap and sell dear” i.e. buy when the shares are selling at a low price and
sell when they are at a high price.
Question 2
(a) What sort of investor normally views the variance (or Standard Deviation) of an
individual security’s return as the security’s proper measure of risk?
(b) What sort of investor rationally views the beta of a security as the security’s proper
measure of risk? In answering the question, explain the concept of beta.
© The Institute of Chartered Accountants of India

7.2 Strategic Financial Management
Answer
(a) A rational risk-averse investor views the variance (or standard deviation) of her portfolio’s
return as the proper risk of her portfolio. If for some reason or another the investor can
hold only one security, the variance of that security’s return becomes the variance of the
portfolio’s return. Hence, the variance of the security’s return is the security’s proper
measure of risk.
While risk is broken into diversifiable and non-diversifiable segments, the market
generally does not reward for diversifiable risk since the investor himself is expected to
diversify the risk himself. However, if the investor does not diversify he cannot be
considered to be an efficient investor. The market, therefore, rewards an investor only for
the non-diversifiable risk. Hence, the investor needs to know how much non-diversifiable
risk he is taking. This is measured in terms of beta.
An investor therefore, views the beta of a security as a proper measure of risk, in
evaluating how much the market reward him for the non-diversifiable risk that he is
assuming in relation to a security. An investor who is evaluating the non-diversifiable
element of risk, that is, extent of deviation of returns viz-a-viz the market therefore
consider beta as a proper measure of risk.
(b) If an individual holds a diversified portfolio, she still views the variance (or standard
deviation) of her portfolios return as the proper measure of the risk of her portfolio.
However, she is no longer interested in the variance of each individual security’s return.
Rather she is interested in the contribution of each individual security to the variance of
the portfolio.
Under the assumption of homogeneous expectations, all individuals hold the market
portfolio. Thus, we measure risk as the contribution of an individual security to the
variance of the market portfolio. The contribution when standardized properly is the beta
of the security. While a very few investors hold the market portfolio exactly, many hold
reasonably diversified portfolio. These portfolios are close enough to the market portfolio
so that the beta of a security is likely to be a reasonable measure of its risk.
In other words, beta of a stock measures the sensitivity of the stock with reference to a
broad based market index like BSE sensex. For example, a beta of 1.3 for a stock would
indicate that this stock is 30 per cent riskier than the sensex. Similarly, a beta of a 0.8
would indicate that the stock is 20 per cent (100 – 80) less risky than the sensex.
However, a beta of one would indicate that the stock is as risky as the stock market
index.
Question 3
Distinguish between ‘Systematic risk’ and ‘Unsystematic risk’.

Portfolio Theory 7.3
Answer
Systematic risk refers to the variability of return on stocks or portfolio associated with changes in
return on the market as a whole. It arises due to risk factors that affect the overall market such as
changes in the nations’ economy, tax reform by the Government or a change in the world energy
situation. These are risks that affect securities overall and, consequently, cannot be diversified
away. This is the risk which is common to an entire class of assets or liabilities. The value of
investments may decline over a given time period simply because of economic changes or other
events that impact large portions of the market. Asset allocation and diversification can protect
against systematic risk because different portions of the market tend to underperform at different
times. This is also called market risk.
Unsystematic risk however, refers to risk unique to a particular company or industry. It is
avoidable through diversification. This is the risk of price change due to the unique
circumstances of a specific security as opposed to the overall market. This risk can be virtually
eliminated from a portfolio through diversification.
Question 4
Briefly explain the objectives of “Portfolio Management”.
Answer
Objectives of Portfolio Management
Portfolio management is concerned with efficient management of portfolio investment in
financial assets, including shares and debentures of companies. The management may be by
professionals or others or by individuals themselves. A portfolio of an individual or a corporate
unit is the holding of securities and investment in financial assets. These holdings are the
result of individual preferences and decisions regarding risk and return.
The investors would like to have the following objectives of portfolio management:
(a) Capital appreciation.
(b) Safety or security of an investment.
(c) Income by way of dividends and interest.
(d) Marketability.
(e) Liquidity.
(f) Tax Planning - Capital Gains Tax, Income tax and Wealth Tax.
(g) Risk avoidance or minimization of risk.
(h) Diversification, i.e. combining securities in a way which will reduce risk.
It is necessary that all investment proposals should be assessed in terms of income, capital
appreciation, liquidity, safety, tax implication, maturity and marketability i.e., saleability (i.e.,
saleability of securities in the market). The investment strategy should be based on the above

objectives after a thorough study of goals of the investor, market situation, credit policy and
economic environment affecting the financial market.
The portfolio management is a complex task. Investment matrix is one of the many
approaches which may be used in this connection. The various considerations involved in
investment decisions are liquidity, safety and yield of the investment. Image of the
organization is also to be taken into account. These considerations may be taken into account
and an overall view obtained through a matrix approach by allotting marks for each
consideration and totaling them.
Question 5
Discuss the various kinds of Systematic and Unsystematic risk?
Answer
There are two types of Risk - Systematic (or non-diversifiable) and unsystematic (or
diversifiable) relevant for investment - also, called as general and specific risk.
Types of Systematic Risk
(i) Market risk: Even if the earning power of the corporate sector and the interest rate
structure remain more or less uncharged prices of securities, equity shares in particular,
tend to fluctuate. Major cause appears to be the changing psychology of the investors.
The irrationality in the security markets may cause losses unrelated to the basic risks.
These losses are the result of changes in the general tenor of the market and are called
market risks.
(ii) Interest Rate Risk: The change in the interest rate has a bearing on the welfare of the
investors. As the interest rate goes up, the market price of existing fixed income
securities falls and vice versa. This happens because the buyer of a fixed income
security would not buy it at its par value or face value if its fixed interest rate is lower
than the prevailing interest rate on a similar security.
(iii) Social or Regulatory Risk: The social or regulatory risk arises, where an otherwise
profitable investment is impaired as a result of adverse legislation, harsh regulatory
climate, or in extreme instance nationalization by a socialistic government.
(iv) Purchasing Power Risk: Inflation or rise in prices lead to rise in costs of production, lower
margins, wage rises and profit squeezing etc. The return expected by investors will
change due to change in real value of returns.
Classification of Unsystematic Risk
(i) Business Risk: As a holder of corporate securities (equity shares or debentures) one is
exposed to the risk of poor business performance. This may be caused by a variety of
factors like heigthtened competition, emergence of new technologies, development of
substitute products, shifts in consumer preferences, inadequate supply of essential

inputs, changes in governmental policies and so on. Often of course the principal factor
may be inept and incompetent management.
(ii) Financial Risk: This relates to the method of financing, adopted by the company, high
leverage leading to larger debt servicing problem or short term liquidity problems due to
bad debts, delayed receivables and fall in current assets or rise in current liabilities.
(iii) Default Risk: Default risk refers to the risk accruing from the fact that a borrower may not
pay interest and/or principal on time. Except in the case of highly risky debt instrument,
investors seem to be more concerned with the perceived risk of default rather than the
actual occurrence of default. Even though the actual default may be highly unlikely, they
believe that a change in the perceived default risk of a bond would have an immediate
impact on its market price.
Question 6
Discuss the Capital Asset Pricing Model (CAPM) and its relevant assumptions.
Answer
Capital Asset Pricing Model: The mechanical complexity of the Markowitz’s portfolio model
kept both practitioners and academics away from adopting the concept for practical use. Its
intuitive logic, however, spurred the creativity of a number of researchers who began
examining the stock market implications that would arise if all investors used this model As a
result what is referred to as the Capital Asset Pricing Model (CAPM), was developed.
The Capital Asset Pricing Model was developed by Sharpe, Mossin and Linter in 1960. The
model explains the relationship between the expected return, non diversifiable risk and the
valuation of securities. It considers the required rate of return of a security on the basis of its
contribution to the total risk. It is based on the premises that the diversifiable risk of a security
is eliminated when more and more securities are added to the portfolio. However, the
systematic risk cannot be diversified and is or related with that of the market portfolio. All
securities do not have same level of systematic risk. The systematic risk can be measured by
beta, ß under CAPM, the expected return from a security can be expressed as:
Expected return on security = Rf + Beta (Rm – Rf)
The model shows that the expected return of a security consists of the risk-free rate of interest
and the risk premium. The CAPM, when plotted on the graph paper is known as the Security
Market Line (SML). A major implication of CAPM is that not only every security but all
portfolios too must plot on SML. This implies that in an efficient market, all securities are
expected returns commensurate with their riskiness, measured by ß.
Relevant Assumptions of CAPM
(i) The investor’s objective is to maximize the utility of terminal wealth;
(ii) Investors make choices on the basis of risk and return;

(iii) Investors have identical time horizon;

(iv) Investors have homogeneous expectations of risk and return;
(v) Information is freely and simultaneously available to investors;
(vi) There is risk-free asset, and investor can borrow and lend unlimited amounts at the risk-
free rate;
(vii) There are no taxes, transaction costs, restrictions on short rates or other market
imperfections;
(viii) Total asset quantity is fixed, and all assets are marketable and divisible.
Thus, CAPM provides a conceptual frame work for evaluating any investment decision where
capital is committed with a goal of producing future returns. However, there are certain
limitations of the theory. Some of these limitations are as follows:
(i) Reliability of Beta: Statistically reliable Beta might not exist for shares of many firms. It
may not be possible to determine the cost of equity of all firms using CAPM. All
shortcomings that apply to Beta value apply to CAPM too.
(ii) Other Risks: It emphasis only on systematic risk while unsystematic risks are also
important to share holders who do not possess a diversified portfolio.
(iii) Information Available: It is extremely difficult to obtain important information on risk-
free interest rate and expected return on market portfolio as there are multiple risk- free
rates for one while for another, markets being volatile it varies over time period.
Question 7
Discuss the Random Walk Theory.
Answer
Many investment managers and stock market analysts believe that stock market prices can
never be predicted because they are not a result of any underlying factors but are mere
statistical ups and downs. This hypothesis is known as Random Walk hypothesis which states
that the behaviour of stock market prices is unpredictable and that there is no relationship
between the present prices of the shares and their future prices. Proponents of this hypothesis
argue that stock market prices are independent. A British statistician, M. G. Kendell, found
that changes in security prices behave nearly as if they are generated by a suitably designed
roulette wheel for which each outcome is statistically independent of the past history. In other
words, the fact that there are peaks and troughs in stock exchange prices is a mere statistical
happening – successive peaks and troughs are unconnected. In the layman's language it may
be said that prices on the stock exchange behave exactly the way a drunk would behave while
walking in a blind lane, i.e., up and down, with an unsteady way going in any direction he
likes, bending on the side once and on the other side the second time.

The supporters of this theory put out a simple argument. It follows that:
(a) Prices of shares in stock market can never be predicted. The reason is that the price
trends are not the result of any underlying factors, but that they represent a statistical
expression of past data.
(c) There may be periodical ups or downs in share prices, but no connection can be
established between two successive peaks (high price of stocks) and troughs (low price
of stocks).
Question 8
Explain the three form of Efficient Market Hypothesis.
Answer
The EMH theory is concerned with speed with which information effects the prices of
securities. As per the study carried out technical analyst it was observed that information is
slowly incorporated in the price and it provides an opportunity to earn excess profit. However,
once the information is incorporated then investor can not earn this excess profit.
Level of Market Efficiency: That price reflects all available information, the highest order of
market efficiency. According to FAMA, there exist three levels of market efficiency:-
(i) Weak form efficiency – Price reflect all information found in the record of past prices and
volumes.
(ii) Semi – Strong efficiency – Price reflect not only all information found in the record of past
prices and volumes but also all other publicly available information.
(iii) Strong form efficiency – Price reflect all available information public as well as private.
Question 9
Explain the different challenges to Efficient Market Theory.
Answer
Information inadequacy – Information is neither freely available nor rapidly transmitted to all
participants in the stock market. There is a calculated attempt by many companies to circulate
misinformation. Other challenges are as follows:
(a) Limited information processing capabilities – Human information processing
capabilities are sharply limited. According to Herbert Simon every human organism lives
in an environment which generates millions of new bits of information every second but
the bottle necks of the perceptual apparatus does not admit more than thousand bits per
seconds and possibly much less.
David Dreman maintained that under conditions of anxiety and uncertainty, with a vast
interacting information grid, the market can become a giant.

(b) Irrational Behaviour – It is generally believed that investors’ rationality will ensure a close
correspondence between market prices and intrinsic values. But in practice this is not true. J.
M. Keynes argued that all sorts of consideration enter into the market valuation which is in no
way relevant to the prospective yield. This was confirmed by L. C. Gupta who found that the
market evaluation processes work haphazardly almost like a blind man firing a gun. The
market seems to function largely on hit or miss tactics rather than on the basis of informed
beliefs about the long term prospects of individual enterprises.
(c) Monopolistic Influence – A market is regarded as highly competitive. No single buyer or
seller is supposed to have undue influence over prices. In practice, powerful institutions
and big operators wield great influence over the market. The monopolistic power enjoyed
by them diminishes the competitiveness of the market.
Question 10
Discuss how the risk associated with securities is affected by Government policy.
Answer
The risk from Government policy to securities can be impacted by any of the following factors.
(i) Licensing Policy
(ii) Restrictions on commodity and stock trading in exchanges
(iii) Changes in FDI and FII rules.
(iv) Export and import restrictions
(v) Restrictions on shareholding in different industry sectors
(vi) Changes in tax laws and corporate and Securities laws.
Question 11
A stock costing ` 120 pays no dividends. The possible prices that the stock might sell for at
the end of the year with the respective probabilities are:
Price Probability
115 0.1
120 0.1
125 0.2
130 0.3
135 0.2
140 0.1
Required:
(i) Calculate the expected return.
(ii) Calculate the Standard deviation of returns.

Answer
Here, the probable returns have to be calculated using the formula
D P1 − P0
R
= +
P0 P0
Calculation of Probable Returns
Possible prices (P1) P1-P0 [(P1-P0)/ P0 ] x 100
` ` Return (per cent)
115 -5 -4.17
120 0 0.00
125 5 4.17
130 10 8.33
135 15 12.50
140 20 16.67
Calculation of Expected Returns
Possible return Probability Product
Xi p(Xi) X1-p(Xi)
-4.17 0.1 -0.417
0.00 0.1 0.000
4.17 0.2 0.834
8.33 0.3 2.499
12.50 0.2 2.500
16.67 0.1 1.667
X = 7.083
Expected return X = 7.083 per

Alternatively, it can also be calculated as follows:
Expected Price = 115 x 0.1 + 120 x 0.1 + 125 x 0.2 + 130 x 0.3 + 135 x 0.2 + 140 x 0.1 = 128.50
128.50 − 120
Return = × 100 = 7.0833%
120

Calculation of Standard Deviation of Returns

Probable Probability Deviation Deviation Product
squared
return Xi p(Xi) (Xi – X) (Xi – X)² (Xi – X)²p(Xi)
-4.17 0.1 -11.253 126.63 12.66
0.00 0.1 -7.083 50.17 5.017
4.17 0.2 -2.913 8.49 1.698
8.33 0.3 1.247 1.56 0.467
12.50 0.2 5.417 29.34 5.869
16.67 0.1 9.587 91.91 9.191
σ² = 34.902
Variance, σ² = 34.902 per cent
Standard deviation, σ= 34.902 = 5.908 per cent
Question 12
Following information is available in respect of expected dividend, market price and market
condition after one year.
Market condition Probability Market Price Dividend per share
` `
Good 0.25 115 9
Normal 0.50 107 5
Bad 0.25 97 3
The existing market price of an equity share is ` 106 (F.V. ` 1), which is cum 10% bonus
debenture of ` 6 each, per share. M/s. X Finance Company Ltd. had offered the buy-back of
debentures at face value.
Find out the expected return and variability of returns of the equity shares if buyback offer is
accepted by the investor.
And also advise-Whether to accept buy back offer?
Answer
The Expected Return of the equity share may be found as follows:
Market Condition Probability Total Return Cost (*) Net Return
Good 0.25 ` 124 ` 100 ` 24

Normal 0.50 ` 112 ` 100 ` 12

Bad 0.25 ` 100 ` 100 `0
 12 
Expected Return = (24 × 0.25) + (12 × 0.50) + (0 × 0.25) = 12=   × 100 =
12%
 100 
The variability of return can be calculated in terms of standard deviation.
V SD = 0.25 (24 – 12)2 + 0.50 (12 – 12)2 + 0.25 (0 – 12)2
= 0.25 (12)2 + 0.50 (0)2 + 0.25 (–12)2
= 36 + 0 + 36
SD = 72
SD = 8.485 or say 8.49
(*) The present market price of the share is ` 106 cum bonus 10% debenture of ` 6 each;
hence the net cost is ` 100.
M/s X Finance company has offered the buyback of debenture at face value. There is
reasonable 10% rate of interest compared to expected return 12% from the market.
Considering the dividend rate and market price the creditworthiness of the company seems to
be very good. The decision regarding buy-back should be taken considering the maturity
period and opportunity in the market. Normally, if the maturity period is low say up to 1 year
better to wait otherwise to opt buy back option.
Question 13
Mr. A is interested to invest ` 1,00,000 in the securities market. He selected two securities B
and D for this purpose. The risk return profile of these securities are as follows :
Security Risk ( σ ) Expected Return (ER)
B 10% 12%
D 18% 20%
Co-efficient of correlation between B and D is 0.15.
You are required to calculate the portfolio return of the following portfolios of B and D to be
considered by A for his investment.
(i) 100 percent investment in B only;
(ii) 50 percent of the fund in B and the rest 50 percent in D;
(iii) 75 percent of the fund in B and the rest 25 percent in D; and
(iv) 100 percent investment in D only.
Also indicate that which portfolio is best for him from risk as well as return point of view?

Answer
We have Ep = W1E1 + W3E3 + ………… WnEn
n n
and for standard deviation σ2 p = ∑∑ w i w jσ ij
i=1 j=1
n n
σ2 p = ∑∑ w i w jρij σ i σ j
i=1 j=1
Two asset portfolio

σ2p = w21σ21 + w22σ22 + 2 w1w2σ1σ2ρ12
Substituting the respective values we get,
(i) All funds invested in B
Ep = 12%
σp = 10%
(ii) 50% of funds in each of B & D
Ep = 0.50X12%+0.50X20%=16%
σ2p = (0.50)2(10%)2 + (0.50)2(18%)2 +2(0.50)(0.50)(0.15)(10%)(18%)
σ2p = 25 + 81 + 13.5 = 119.50
σp = 10.93%
(iii) 75% in B and 25% in D
Ep = 0.75%X12%+0.25%X20=14%
σ2p = (0.75)2(10%)2 + (0.25)2(18%)2 +2(0.75)(0.25)(0.15)(10%)(18%)
σ2p = 56.25 + 20.25 + 10.125 = 86.625
σp = 9.31%
(iv) All funds in D
Ep = 20%
σp = 18.0%
Portfolio (i) (ii) (iii) (iv)
Return 12 16 14 20
σ 10 10.93 9.31 18

In the terms of return, we see that portfolio (iv) is the best portfolio. In terms of risk we see that
portfolio (iii) is the best portfolio.
Question 14
Consider the following information on two stocks, A and B :
Year Return on A (%) Return on B (%)
2016 10 12
2017 16 18
You are required to determine:
(i) The expected return on a portfolio containing A and B in the proportion of 40% and 60%
respectively.
(ii) The Standard Deviation of return from each of the two stocks.
(iii) The covariance of returns from the two stocks.
(iv) Correlation coefficient between the returns of the two stocks.
(v) The risk of a portfolio containing A and B in the proportion of 40% and 60%.
Answer
(i) Expected return of the portfolio A and B
E (A) = (10 + 16) / 2 = 13%
E (B) = (12 + 18) / 2 = 15%
N
Rp = ∑ X iR i = 0.4(13) + 0.6(15) = 14.2%
i −l
(ii) Stock A:
Variance = 0.5 (10 – 13)² + 0.5 (16 – 13) ² = 9
Standard deviation = 9 = 3%
Stock B:
Variance = 0.5 (12 – 15) ² + 0.5 (18 – 15) ² = 9
Standard deviation = 3%
(iii) Covariance of stocks A and B
CovAB = 0.5 (10 – 13) (12 – 15) + 0.5 (16 – 13) (18 – 15) = 9
(iv) Correlation of coefficient
Cov AB 9
rAB = = =1
σ A σB 3 × 3

(v) Portfolio Risk
σP = X 2 A σ2 A + X 2Bσ2B + 2X A X B (σ A σBσ AB )
= (0.4 )2 (3)2 + (0.6)2 (3)2 + 2(0.4 )(0.6)(3)(3)(1)

= 1.44 + 3.24 + 4.32 = 3%
Question 15
Following is the data regarding six securities:
A B C D E F
Return (%) 8 8 12 4 9 8
Risk (Standard deviation) 4 5 12 4 5 6
(i) Assuming three will have to be selected, state which ones will be picked.
(ii) Assuming perfect correlation, show whether it is preferable to invest 75% in A and 25%
in C or to invest 100% in E
Answer
(i) Security A has a return of 8% for a risk of 4, whereas B and F have a higher risk for the
same return. Hence, among them A dominates.
For the same degree of risk 4, security D has only a return of 4%. Hence, D is also
dominated by A.
Securities C and E remain in reckoning as they have a higher return though with higher
degree of risk.
Hence, the ones to be selected are A, C & E.
Alternatively, three securities can also be found as follows:

Since securities other than A, E and C are not on Efficient Frontier they are rejected.
(ii) The average values for A and C for a proportion of 3 : 1 will be :

(3 × 4) + (1× 12)
Risk = = 6%
4
or (0.75)2 ×(4)2 +(0.25)2 ×(12)2 +2×0.75×0.25×4×12×1 = 6%

(3 × 8) + (1× 12)
Return = = 9%
4
Therefore: 75% A E
25% C _
Risk 6 5
Return 9% 9%
For the same 9% return the risk is lower in E. Hence, E will be preferable.
Question 16
The historical rates of return of two securities over the past ten years are given. Calculate the
Covariance and the Correlation coefficient of the two securities:
Years: 1 2 3 4 5 6 7 8 9 10
Security 1: 12 8 7 14 16 15 18 20 16 22
(Return per cent)
Security 2: 20 22 24 18 15 20 24 25 22 20
(Return per cent)
Answer
Calculation of Covariance
Year R1 Deviation Deviation R2 Deviation Deviation Product

of
(R 1 - R 1 ) (R1 - R1) 2 (R 2 - R 2 ) (R 2 - R 2 ) 2
deviations
1 12 -2.8 7.84 20 -1 1 2.8
2 8 -6.8 46.24 22 1 1 -6.8
3 7 -7.8 60.84 24 3 9 -23.4
4 14 -0.8 0.64 18 -3 9 2.4

5 16 1.2 1.44 15 -6 36 -7.2

6 15 0.2 0.04 20 -1 1 -0.2
7 18 3.2 10.24 24 3 9 9.6
8 20 5.2 27.04 25 4 16 20.8
9 16 1.2 1.44 22 1 1 1.2
10 22 7.2 51.84 20 -1 1 -7.2
148 Σ=207.60 210 Σ=84.00
R1 = = 14.8 R2 = = 21
10 10
N
∑
i =1
[R 1 − R 1 ] [R 2 − R 2 ]
Covariance = = -8/10 = -0.8
N
Standard Deviation of Security 1
(R1 - R1) 2
σ1 =
N
207.60
σ1 = = 20.76
10
σ1 = 4.56
Standard Deviation of Security 2
(R 2 - R 2 ) 2
σ2 =
N
84
σ2 = = 8.40
10
σ 2 = 2.90
Alternatively, Standard Deviation of securities can also be calculated as follows:
Calculation of Standard Deviation
Year R1 R 12 R2 R 22
1 12 144 20 400
2 8 64 22 484

3 7 49 24 576
4 14 196 18 324
5 16 256 15 225
6 15 225 20 400
7 18 324 24 576
8 20 400 25 625
9 16 256 22 484
10 22 484 20 400
148 2398 210 4494
Standard deviation of security 1:
σ1 =
N ∑R12 - (∑R1)2
N2
(10 × 2398) - (148) 2 23980 - 21904

= =
10 ×10 100
= 20.76 = 4.56
Standard deviation of security 2:
σ2 =
N ∑ R − (∑ R
2
2 2)
2
N2
(10 × 4494) − (210) 2 44940− 44100

= =
10 × 10 100
840
= = 8.4 = 2.90
100
Correlation Coefficient
Cov − 0.8 − 0.8
r12 = = = = -0.0605
σ1 σ 2 4.56 × 2.90 13.22
Question 17
An investor has decided to invest to invest ` 1,00,000 in the shares of two companies,
namely, ABC and XYZ. The projections of returns from the shares of the two companies along
with their probabilities are as follows:

Probability ABC(%) XYZ(%)

.20 12 16
.25 14 10
.25 -7 28
.30 28 -2
You are required to
(i) Comment on return and risk of investment in individual shares.
(ii) Compare the risk and return of these two shares with a Portfolio of these shares in equal
proportions.
(iii) Find out the proportion of each of the above shares to formulate a minimum risk portfolio.
Answer
(i)
Probability ABC (%) XYZ (%) 1X2 (%) 1X3 (%)
(1) (2) (3) (4) (5)
0.20 12 16 2.40 3.2
0.25 14 10 3.50 2.5
0.25 -7 28 -1.75 7.0
0.30 28 -2 8.40 -0.6
Average return 12.55 12.1
Hence the expected return from ABC = 12.55% and XYZ is 12.1%
Probability (ABC- (ABC- 1X3 (XYZ- (XYZ- (1)X(6)
ABC ) ABC )2 XYZ XYZ )
) 2
(1) (2) (3) (4) (5) (6)

0.20 -0.55 0.3025 0.06 3.9 15.21 3.04
0.25 1.45 2.1025 0.53 -2.1 4.41 1.10
0.25 -19.55 382.2025 95.55 15.9 252.81 63.20
0.30 15.45 238.7025 71.61 -14.1 198.81 59.64
167.75 126.98
σ 2 ABC = 167.75(%)2 ; σ ABC = 12.95%
σ 2 XYZ = 126.98(%)2 ; σ XYZ = 11.27%

(ii) In order to find risk of portfolio of two shares, the covariance between the two is
necessary here.
Probability (ABC- ABC ) (XYZ- XYZ ) 2X3 1X4
(1) (2) (3) (4) (5)
0.20 -0.55 3.9 -2.145 -0.429
0.25 1.45 -2.1 -3.045 -0.761
0.25 -19.55 15.9 -310.845 -77.71
0.30 15.45 -14.1 -217.845 -65.35
-144.25
σ 2P = (0.52 x 167.75) + (0.52 x 126.98) + 2 x (-144.25) x 0.5 x 0.5
σ 2P = 41.9375 + 31.745 – 72.125
σ 2P = 1.5575 or 1.56(%)
σ P = 1.56 = 1.25%
E (Rp) = (0.5 x 12.55) + (0.5 x 12.1) = 12.325%
Hence, the return is 12.325% with the risk of 1.25% for the portfolio. Thus the portfolio
results in the reduction of risk by the combination of two shares.
(iii) For constructing the minimum risk portfolio the condition to be satisfied is
σ X2 - rAX σ A σ X σ 2X - Cov.AX
XABC = or =
σ 2A + σ X2 - 2rAX σ A σ X σ 2A + σ 2X - 2 Cov.AX
σX = Std. Deviation of XYZ

σA = Std. Deviation of ABC
rAX= Coefficient of Correlation between XYZ and ABC
Cov.AX = Covariance between XYZ and ABC.
Therefore,
126.98 - (-144.25) 271.23
% ABC = = = 0.46 or 46%
[ ]
126.98 + 167.75 - 2 × (-144.25) 583.23
% ABC = 46%, XYZ = 54%

(1 – 0.46) =0.54

Question 18
The following information are available with respect of Krishna Ltd.
Krishna Ltd.
Dividend Average Market Dividend Return on
Year Average share
per Share Index Yield Govt. bonds
price
` `
2012 245 20 2013 4% 7%
2013 253 22 2130 5% 6%
2014 310 25 2350 6% 6%
2015 330 30 2580 7% 6%
Compute Beta Value of the Krishna Ltd. at the end of 2015 and state your observation.
Answer
(i) Computation of Beta Value
Calculation of Returns
D1 + (P1 − P0 )
Returns = × 100
P0
Year Returns
22 + (253 − 245)
2012 – 13 × 100 = 12.24%
245
25 + (310 − 253)
2013 – 14 × 100 = 32.41%
253
30 + (330 − 310)
2014 – 15 × 100 = 16.13%
310
Calculation of Returns from market Index
Year % of Index Appreciation Dividend Yield % Total Return %
(2130 − 2013)
2012–13 × 100 = 5.81% 5% 10.81%
2013
(2350 − 2130)
2013–14 × 100 = 10.33% 6% 16.33%
2130

(2580 − 2350)
2014–15 × 100 = 9.79% 7% 16.79%
2350
Computation of Beta
Year Krishna Ltd. (X) Market Index (Y) XY Y2

2012–13 12.24% 10.81% 132.31 116.86
2013–14 32.41% 16.33% 529.25 266.67
2014–15 16.13% 16.79% 270.82 281.90
Total 60.78% 43.93% 932.38 665.43
60.78
Average Return of Krishna Ltd. = = 20.26%
3
43.93
Average Market Return = = 14.64%
3
Beta (β) =
∑ XY - nX Y = 932.38 - 3 × 20.26 × 14.64
= 1.897
∑ Y − n(Y ) 665.43 - 3(14.64)2
2 2
(ii) Observation
Expected Return (%) Actual Return (%) Action
2012 – 13 6%+ 1.897(10.81% - 6%) = 15.12% 12.24% Sell
2013 – 14 6%+ 1.897(16.33% - 6%) = 25.60% 32.41% Buy
2014 – 15 6%+ 1.897(16.79% - 6%) = 26.47% 16.13% Sell
Question 19
The distribution of return of security ‘F’ and the market portfolio ‘P’ is given below:
Probability Return %
F P
0.30 30 -10
0.40 20 20
0.30 0 30

You are required to calculate the expected return of security ‘F’ and the market portfolio ‘P’,
the covariance between the market portfolio and security and beta for the security.
Answer
Security F
Prob(P) Rf PxR f Deviations of (Deviation) 2 (Deviations) 2
F of F PX
(Rf – ERf)
0.3 30 9 13 169 50.7
0.4 20 8 3 9 3.6
0.3 0 0 -17 289 86.7
ER f =17 Var f =141
STDEV σ f = 141 = 11.87

Market Portfolio, P
RM PM Exp. Dev. of P (Dev. of (DeV.) 2 P M (Deviation Dev. of F x
% Return (R M -ER M ) P) 2 of F) x Dev. of P)
RM x PM (Deviation x P
of P)
-10 0.3 -3 -24 576 172.8 -312 -93.6
20 0.4 8 6 36 14.4 18 7.2
30 0.3 9 16 256 76.8 -272 -81.6
ER M =14 Var M =264 =Co Var P M
σ M =16.25 =- 168
Co Var PM − 168
Beta= = = − .636
σ M2 264
Question 20
Given below is information of market rates of Returns and Data from two Companies A and B:
Year 2007 Year 2008 Year 2009
Market (%) 12.0 11.0 9.0
Company A (%) 13.0 11.5 9.8
Company B (%) 11.0 10.5 9.5
You are required to determine the beta coefficients of the Shares of Company A and Company B.

Answer
Company A:
Year Return % (Ra) Market return Deviation Deviation D Ra × Rm 2

% (Rm) R(a) Rm DRm
1 13.0 12.0 1.57 1.33 2.09 1.77
2 11.5 11.0 0.07 0.33 0.02 0.11
3 9.8 9.0 −1.63 −1.67 2.72 2.79
34.3 32.0 4.83 4.67
Average Ra = 11.43
Average Rm = 10.67
Covariance =
∑ (Rm - Rm )(Ra - R a )
N
4.83
Covariance = = 1.61
3
Variance (σm 2) =
∑ (R m - R m ) 2
N
4.67
= = 1.557
3
1.61
β= = 1.03
1.557
Company B:
Year Return % (Rb) Market return % Deviation Deviation D Rb × D Rm2
(Rm) R(b) Rm Rm
1 11.0 12.0 0.67 1.33 0.89 1.77
2 10.5 11.0 0.17 0.33 0.06 0.11
3 9.5 9.0 −0.83 −1.67 1.39 2.79
31.0 32.0 2.34 4.67
Average Rb = 10.33
Average Rm = 10.67

Covariance =
∑ (Rm - Rm )(Rb - Rb )
N
2.34
Covariance = = 0.78
3
Variance (σ m 2) =
∑ (Rm - Rm )2
N
4.67
= = 1.557
3
0.78
β= = 0.50
1.557
Question 21
The returns on stock A and market portfolio for a period of 6 years are as follows:
Year Return on A (%) Return on market portfolio (%)
1 12 8
2 15 12
3 11 11
4 2 -4
5 10 9.5
6 -12 -2
You are required to determine:
(i) Characteristic line for stock A
(ii) The systematic and unsystematic risk of stock A.
Answer
Characteristic line is given by
αi+ βiRm
Σxy − n x y
βi =
Σx 2 − n(x) 2
αi = y − β x

Return Return xy x2 (x- x) (x- x) 2 (y- y ) (y- y ) 2

on A on
(Y) market
(X)
12 8 96 64 2.25 5.06 5.67 32.15
15 12 180 144 6.25 39.06 8.67 75.17
11 11 121 121 5.25 27.56 4.67 21.81
2 -4 -8 16 -9.75 95.06 -4.33 18.75
10 9.5 95 90.25 3.75 14.06 3.67 13.47
-12 -2_ 24 4 -7.75 60.06 -18.33 335.99
38 34.5 508 439.25 240.86 497.34
y = 38 = 6.33
6
x = 34.5 = 5.75
6
Σxy − n x y 508 − 6 (5.75) (6.33) 508 − 218.385
βi = 2 2
= 2
=
Σx − n( x) 439.25 − 6(5.75) 439.25 − 198.375
289.615
= = 1.202
240.875
α = y - β x = 6.33 – 1.202 (5.75) = - 0.58
Hence the characteristic line is -0.58 + 1.202 (Rm)
240.86
Total Risk of Market = σ m 2 = Σ( x - x ) 2 = = 40.14(%)
n 6
497.34
Total Risk of Stock = = 82.89 (%)
6
Systematic Risk = βi 2 σ m2 = (1.202)2 x 40.14 = 57.99(%)
Unsystematic Risk is = Total Risk – Systematic Risk

= 82.89 - 57.99 = 24.90(%)
Question 22
The rates of return on the security of Company X and market portfolio for 10 periods are given
below:

Period Return of Security X (%) Return on Market Portfolio (%)

1 20 22
2 22 20
3 25 18
4 21 16
5 18 20
6 −5 8
7 17 −6
8 19 5
9 −7 6
10 20 11
(i) What is the beta of Security X?
(ii) What is the characteristic line for Security X?
Answer
(i)
Period R X RM R X − R X RM − RM (R X )(
− R X RM − RM ) (R M − RM )
2
1 20 22 5 10 50 100
2 22 20 7 8 56 64
3 25 18 10 6 60 36
4 21 16 6 4 24 16
5 18 20 3 8 24 64
6 -5 8 -20 -4 80 16
7 17 -6 2 -18 -36 324
8 19 5 4 -7 -28 49
9 -7 6 -22 -6 132 36
10 20 11 5 -1 -5 1
150 120 357 706
ΣRX ΣRM ∑ (R X − R X )(R M − R M ) ∑ (R M − R M )
2
R X = 15 R M = 12

2
 −

∑  RM − RM 
  = 706
σ2 M = = 70.60
n 10
 −
 −

∑  R X − R X  R M − R M 
  = 357 = 35.70
Cov X M =
n 10
Cov X M m 35.70
Beta x = = = 0.505
σ 2M 70.60
Alternative Solution
Period X Y Y2 XY
1 20 22 484 440
2 22 20 400 440
3 25 18 324 450
4 21 16 256 336
5 18 20 400 360
6 -5 8 64 -40
7 17 -6 36 -102
8 19 5 25 95
9 -7 6 36 -42
10 20 11 121 220
150 120 2146 2157
X = 15 Y = 12
ΣXY - n X Y
=
ΣX 2 - n(X)2
2157 - 10 × 15 × 12 357
= = = 0.506
2146 - 10 × 12 × 12 706
(ii) R X = 15 R M = 12
y = α + βx
15 = α + 0.505 × 12
Alpha (α) = 15 – (0.505 × 12) = 8.94%

Characteristic line for security X = α + β × RM

Where, RM = Expected return on Market Index
∴Characteristic line for security X = 8.94 + 0.505 RM
Question 23
Expected returns on two stocks for particular market returns are given in the following table:
Market Return Aggressive Defensive
7% 4% 9%
25% 40% 18%
You are required to calculate:
(a) The Betas of the two stocks.
(b) Expected return of each stock, if the market return is equally likely to be 7% or 25%.
(c) The Security Market Line (SML), if the risk free rate is 7.5% and market return is equally
likely to be 7% or 25%.
(d) The Alphas of the two stocks.
Answer
(a) The Betas of two stocks:
Aggressive stock - 40% - 4%/25% - 7% = 2
Defensive stock - 18% - 9%/25% - 7% = 0.50
Alternatively, it can also be solved by using the Characteristic Line Relationship as follows:
Rs = α + βRm
Where
α = Alpha
β = Beta
Rm= Market Return
For Aggressive Stock
4% = α + β(7%)
40% = α + β(25%)
36% = β(18%)
β=2

For Defensive Stock

9% = α + β(7%)
18% = α + β(25%)
9% = β(18%)
β =0.50
(b) Expected returns of the two stocks:-
Aggressive stock - 0.5 x 4% + 0.5 x 40% = 22%
Defensive stock - 0.5 x 9% + 0.5 x 18% = 13.5%
(c) Expected return of market portfolio = 0.5 x 7% + 0.5% x 25% = 16%
∴ Market risk prem. = 16% - 7.5% = 8.5%
∴ SML is, required return = 7.5% + βi 8.5%
(d) Rs = α + βRm
For Aggressive Stock
22% = αA + 2(16%)
αA = -10%
For Defensive Stock
13.5% = αD + 0.50(16%)
αD = 5.5%
Question 24
A study by a Mutual fund has revealed the following data in respect of three securities:
Security σ (%) Correlation with
Index, Pm
A 20 0.60
B 18 0.95
C 12 0.75
The standard deviation of market portfolio (BSE Sensex) is observed to be 15%.
(i) What is the sensitivity of returns of each stock with respect to the market?
(ii) What are the covariances among the various stocks?
(iii) What would be the risk of portfolio consisting of all the three stocks equally?
(iv) What is the beta of the portfolio consisting of equal investment in each stock?
(v) What is the total, systematic and unsystematic risk of the portfolio in (iv) ?

Answer
(i) Sensitivity of each stock with market is given by its beta.
Standard deviation of market Index = 15%
Variance of market Index = 0.0225
Beta of stocks = σi r/ σ m
A = 20 × 0.60/15 = 0.80
B = 18 × 0.95/15 = 1.14
C = 12 × 0.75/15 = 0.60
(ii) Covariance between any 2 stocks = β 1β 2 σ 2m
Covariance matrix
Stock/Beta 0.80 1.14 0.60
A 400.000 205.200 108.000
B 205.200 324.000 153.900
C 108.000 153.900 144.000
(iii) Total risk of the equally weighted portfolio (Variance) = 400(1/3)2 + 324(1/3)2 + 144(1/3)2
+ 2 (205.20)(1/3)2 + 2(108.0)(1/3)2 + 2(153.900) (1/3)2 = 200.244
0.80 + 1.14 + 0.60
(iv) β of equally weighted portfolio = β p = ∑ β i/N =
3
= 0.8467
(v) Systematic Risk β P2 σ m2 = (0.8467)2 (15)2 =161.302
Unsystematic Risk = Total Risk – Systematic Risk
= 200.244 – 161.302 = 38.942
Question 25
Mr. X owns a portfolio with the following characteristics:
Security A Security B Risk Free security
Factor 1 sensitivity 0.80 1.50 0
Factor 2 sensitivity 0.60 1.20 0
Expected Return 15% 20% 10%
It is assumed that security returns are generated by a two factor model.

(i) If Mr. X has ` 1,00,000 to invest and sells short ` 50,000 of security B and purchases
` 1,50,000 of security A what is the sensitivity of Mr. X’s portfolio to the two factors?
(ii) If Mr. X borrows ` 1,00,000 at the risk free rate and invests the amount he borrows along
with the original amount of ` 1,00,000 in security A and B in the same proportion as
described in part (i), what is the sensitivity of the portfolio to the two factors?
(iii) What is the expected return premium of factor 2?
Answer
(i) Mr. X’s position in the two securities are +1.50 in security A and -0.5 in security B. Hence
the portfolio sensitivities to the two factors:-
b prop. 1 =1.50 x 0.80 + (-0.50 x 1.50) = 0.45
b prop. 2 = 1.50 x 0.60 + (-0.50 x 1.20) = 0.30
(ii) Mr. X’s current position:-
Security A ` 3,00,000 / ` 1,00,000 = 3
Security B -` 1,00,000 / ` 1,00,000 = -1
Risk free asset -` 100000 / ` 100000 = -1
b prop. 1 = 3.0 x 0.80 + (-1 x 1.50) + (- 1 x 0) = 0.90
b prop. 2 = 3.0 x 0.60 + (-1 x 1.20) + (-1 x 0) = 0.60
(iii) Expected Return = Risk Free Rate of Return + Risk Premium
Let λ1 and λ2 are the Value Factor 1 and Factor 2 respectively.
Accordingly
15 = 10 + 0.80 λ1 + 0.60 λ2
20 = 10 + 1.50 λ1 + 1.20 λ2
On solving equation, the value of λ 1 = 0, and Securities A & B shall be as follows:
Security A
Total Return = 15%
Risk Free Return = 10%
Risk Premium = 5%
Security B
Total Return = 20%
Risk Free Return = 10%
Risk Premium = 10%

Question 26
Mr. Tempest has the following portfolio of four shares:
Name Beta Investment ` Lac.
Oxy Rin Ltd. 0.45 0.80
Boxed Ltd. 0.35 1.50
Square Ltd. 1.15 2.25
Ellipse Ltd. 1.85 4.50
The risk-free rate of return is 7% and the market rate of return is 14%.
Required.
(i) Determine the portfolio return. (ii) Calculate the portfolio Beta.
Answer
Market Risk Premium (A) = 14% – 7% = 7%
Share Beta Risk Premium (Beta Risk Free Return Return
x A) % Return % % `
Oxy Rin Ltd. 0.45 3.15 7 10.15 8,120
Boxed Ltd. 0.35 2.45 7 9.45 14,175
Square Ltd. 1.15 8.05 7 15.05 33,863
Ellipse Ltd. 1.85 12.95 7 19.95 89,775
Total Return 1,45,933
Total Investment ` 9,05,000
` 1,45,933
(i) Portfolio Return = × 100 = 16.13%
` 9,05,000
(ii) Portfolio Beta
Portfolio Return = Risk Free Rate + Risk Premium х β = 16.13%
7% + 7β = 16.13%
β = 1.30
Alternative Approach
First we shall compute Portfolio Beta using the weighted average method as follows:
0.80 1.50 2.25 4.50
BetaP = 0.45X + 0.35X + 1.15X + 1.85X
9.05 9.05 9.05 9.05

= 0.45x0.0884+ 0.35X0.1657+ 1.15X0.2486+ 1.85X0.4972 = 0.0398+ 0.058 + 0.2859 +

0.9198 = 1.3035
Accordingly,
(i) Portfolio Return using CAPM formula will be as follows:
RP= RF + BetaP(RM – RF)
= 7% + 1.3035(14% - 7%) = 7% + 1.3035(7%)
= 7% + 9.1245% = 16.1245%
(ii) Portfolio Beta
As calculated above 1.3035
Question 27
Mr. Abhishek is interested in investing ` 2,00,000 for which he is considering following three
alternatives:
(i) Invest ` 2,00,000 in Mutual Fund X (MFX)
(ii) Invest ` 2,00,000 in Mutual Fund Y (MFY)
(iii) Invest ` 1,20,000 in Mutual Fund X (MFX) and ` 80,000 in Mutual Fund Y (MFY)
Average annual return earned by MFX and MFY is 15% and 14% respectively. Risk free rate of
return is 10% and market rate of return is 12%.
Covariance of returns of MFX, MFY and market portfolio Mix are as follow:
MFX MFY Mix

MFX 4.800 4.300 3.370
MFY 4.300 4.250 2.800
Mix 3.370 2.800 3.100
You are required to calculate:
(i) variance of return from MFX, MFY and market return,
(ii) portfolio return, beta, portfolio variance and portfolio standard deviation,
(ill) expected return, systematic risk and unsystematic risk; and
(iv) Sharpe ratio, Treynor ratio and Alpha of MFX, MFY and Portfolio Mix
Answer
(i) Variance of Returns
Cov (i, j)
Cor i,j =
σ iσ j

Accordingly, for MFX

Cov (X, X)
1=
σXσX
σ 2X = 4.800
Accordingly, for MFY
Cov (Y, Y)
1=
σ Yσ Y
σ 2Y = 4.250
Accordingly, for Market Return
Cov (M, M)
1=
σMσM
σ M2 = 3.100
(ii) Portfolio return, beta, variance and standard deviation
1,20,000
Weight of MFX in portfolio = =0.60
2,00,000
80,000
Weight of MFY in portfolio = =0.40
2,00,000
Accordingly Portfolio Return
0.60 × 15% + 0.40 × 14% = 14.60%
Beta of each Fund
Cov (Fund,Market )
β=
Variance of Market
3.370
β = = 1.087
X 3.100
2.800
β = = 0.903
Y 3.100
Portfolio Beta
0.60 x 1.087 + 0.40 x 0.903 = 1.013
Portfolio Variance

σ 2XY = w 2X σ 2X + w 2Y σ 2Y + 2 w X w Y Cov X,Y

= (0.60)2 (4.800) + (0.40)2 (4.250) + 2(0.60) (0.40) (4.300)
= 4.472
Or Portfolio Standard Deviation
σ XY = 4.472 = 2.115
(iii) Expected Return, Systematic and Unsystematic Risk of Portfolio
Portfolio Return = 10% + 1.0134(12% - 10%) = 12.03%
MF X Return = 10% + 1.087(12% - 10%) = 12.17%
MF Y Return = 10% + 0.903(12% - 10%) = 28.06%
Systematic Risk = β 2σ2
Accordingly,
Systematic Risk of MFX = (1.087)2 x 3.10 = 3.663
Systematic Risk of MFY = (0.903)2 x 3.10 = 2.528
Systematic Risk of Portfolio = (1.013)2 x 3.10 = 3.181
Unsystematic Risk = Total Risk – Systematic Risk
Accordingly,
Unsystematic Risk of MFX = 4.80 – 3.663 = 1.137
UnSystematic Risk of MFY = 4.250 – 2.528 = 1.722
UnSystematic Risk of Portfolio = 4.472 – 3.181 = 1.291
(iv) Sharpe and Treynor Ratios and Alpha
Sharpe Ratio
15% - 10%
MFX = = 2.282
4.800
14% - 10%
MFY = = 1.94
4.250
14.6% - 10%
Portfolio = = 2.175
2.115

Treynor Ratio
15% - 10%
MFX = = 4.60
1.087
14% - 10%
MFY = = 4.43
0.903
14.6% - 10%
Portfolio = = 4.54
1.0134
Alpha
MFX = 15% - 12.17% = 2.83%
MFY = 14% - 11.81% = 2.19%
Portfolio = 14.6% - 12.03% = 2.57%
Question 28
Amal Ltd. has been maintaining a growth rate of 12% in dividends. The company has paid
dividend @ ` 3 per share. The rate of return on market portfolio is 15% and the risk-free rate
of return in the market has been observed as10%. The beta co-efficient of the company’s
share is 1.2.
You are required to calculate the expected rate of return on the company’s shares as per
CAPM model and the equilibirium price per share by dividend growth model.
Answer
Capital Asset Pricing Model (CAPM) formula for calculation of expected rate of return is
ER = Rf + β (Rm – Rf)
ER = Expected Return
β = Beta of Security
Rm = Market Return
Rf = Risk free Rate
= 10 + [1.2 (15 – 10)]
= 10 + 1.2 (5)
= 10 + 6 = 16% or 0.16
Applying dividend growth mode for the calculation of per share equilibrium price:-
D1
ER = +g
P0

3(1.12) 3.36
or 0.16 = + 0.12 or 0.16 – 0.12 =
P0 P0
3.36
or 0.04 P0 = 3.36 or P0 = = ` 84
0.04
Therefore, equilibrium price per share will be ` 84.
Question 29
The following information is available in respect of Security X
Equilibrium Return 15%
Market Return 15%
7% Treasury Bond Trading at $140
Covariance of Market Return and Security Return 225%
Coefficient of Correlation 0.75
You are required to determine the Standard Deviation of Market Return and Security Return.
Answer
First we shall compute the β of Security X.
Coupon Payment 7
Risk Free Rate = = = 5%
Current Market Price 140
Assuming equilibrium return to be equal to CAPM return then:
15% = Rf + βX(Rm- Rf)
15%= 5% + βX(15%- 5%)
βX = 1
or it can also be computed as follows:
R m 15%
= =1
R s 15%
(i) Standard Deviation of Market Return

Cov X,m 225%
βm = = =1
σm2 σm2
σ2m = 225

σm = 225 = 15%
(ii) Standard Deviation of Security Return
σX σ
βX = × ρXm = X × 0.75 =1
σm 15
15
σX = = 20%
0.75
Question 30
Assuming that shares of ABC Ltd. and XYZ Ltd. are correctly priced according to Capital Asset
Pricing Model. The expected return from and Beta of these shares are as follows:
Share Beta Expected return
ABC 1.2 19.8%
XYZ 0.9 17.1%
You are required to derive Security Market Line.
Answer
CAPM = Rf+ β (Rm –Rf)
Accordingly
RABC = Rf+1.2 (Rm – Rf) = 19.8
RXYZ = Rf+ 0.9 (Rm – Rf) = 17.1
19.8 = Rf+1.2 (Rm – Rf) ------(1)
17.1 = Rf+0.9 (Rm – Rf) ------(2)
Deduct (2) from (1)
2.7 = 0.3 (Rm – R f)
Rm – Rf = 9
R f = Rm – 9
Substituting in equation (1)
19.8 = (Rm – 9) + 1.2 (Rm – Rm+ 9)
19.8 = Rm - 9 + 10.8
19.8 = Rm+1.8
Then Rm=18% and Rf= 9%
Security Market Line = Rf+ β (Market Risk Premium) = 9% + β × 9%

Question 31
A Ltd. has an expected return of 22% and Standard deviation of 40%. B Ltd. has an expected
return of 24% and Standard deviation of 38%. A Ltd. has a beta of 0.86 and B Ltd. a beta of
1.24. The correlation coefficient between the return of A Ltd. and B Ltd. is 0.72. The Standard
deviation of the market return is 20%. Suggest:
(i) Is investing in B Ltd. better than investing in A Ltd.?
(ii) If you invest 30% in B Ltd. and 70% in A Ltd., what is your expected rate of return and
portfolio Standard deviation?
(iii) What is the market portfolios expected rate of return and how much is the risk-free rate?
(iv) What is the beta of Portfolio if A Ltd.’s weight is 70% and B Ltd.’s weight is 30%?
Answer
(i) A Ltd. has lower return and higher risk than B Ltd. investing in B Ltd. is better than in A
Ltd. because the returns are higher and the risk, lower. However, investing in both will
yield diversification advantage.
(ii) rAB = .22 × 0.7 + .24 × 0.3 = 22.6%
σ 2AB = 0.402 X 0.72 + 0.382 X 0.32 + 2X 0.7 X 0.3 X 0.72 X 0.40 X 0.38 =0.1374
σ AB = σ 2AB = .1374 = .37 = 37% *

* Answer = 37.06% is also correct and variation may occur due to approximation.
(iii) This risk-free rate will be the same for A and B Ltd. Their rates of return are given as
follows:
rA = 22 = rf + (rm – rf) 0.86
rB = 24 = rf + (rm – rf) 1.24
rA – rB = –2 = (rm – rf) (–0.38)
rm – rf = –2/–0.38 = 5.26%
rA = 22 = rf + (5.26) 0.86
rf = 17.5%*
rB = 24 = rf + (5.26) 1.24
rf = 17.5%*
rm – 17.5 = 5.26
rm = 22.76%**

*Answer = 17.47% might occur due to variation in approximation.

**Answer may show small variation due to approximation. Exact answer is 22.73%.
(iv) β AB = β A × WA + β B × WB
= 0.86 × 0.7 + 1.24 × 0.3 = 0.974
Question 32
XYZ Ltd. has substantial cash flow and until the surplus funds are utilised to meet the future
capital expenditure, likely to happen after several months, are invested in a portfolio of short-
term equity investments, details for which are given below:
Investment No. of shares Beta Market price per share Expected dividend yield
`
I 60,000 1.16 4.29 19.50%
II 80,000 2.28 2.92 24.00%
III 1,00,000 0.90 2.17 17.50%
IV 1,25,000 1.50 3.14 26.00%
The current market return is 19% and the risk free rate is 11%.
Required to:
(i) Calculate the risk of XYZ’s short-term investment portfolio relative to that of the market;
(ii) Whether XYZ should change the composition of its portfolio.
Answer
(i) Computation of Beta of Portfolio
Investment No. of Market Market Dividend Dividend Composition β Weighted
shares Price Value Yield β
I. 60,000 4.29 2,57,400 19.50% 50,193 0.2339 1.16 0.27
II. 80,000 2.92 2,33,600 24.00% 56,064 0.2123 2.28 0.48
III. 1,00,000 2.17 2,17,000 17.50% 37,975 0.1972 0.90 0.18
IV. 1,25,000 3.14 3,92,500 26.00% 1,02,050 0.3566 1.50 0.53
11,00,500 2,46,282 1.0000 1.46
2,46,282
Return of the Portfolio = 0.2238
11,00,500
Beta of Port Folio 1.46

Market Risk implicit

0.2238 = 0.11 + β× (0.19 – 0.11)
Or, 0.08 β + 0.11 = 0.2238
0.2238 − 0.11
β= = 1.42
0.08
Market β implicit is 1.42 while the port folio β is 1.46. Thus the portfolio is marginally
risky compared to the market.
(ii) The decision regarding change of composition may be taken by comparing the dividend
yield (given) and the expected return as per CAPM as follows:
Expected return Rs as per CAPM is:
Rs = IRF + (RM – I RF) β
For investment I Rs = IRF + (RM – IRF) β
= .11 + (.19 - .11) 1.16
= 20.28%
For investment II, Rs = .11 + (.19 - .11) 2.28 = 29.24%
For investment III, Rs = .11 + (.19 - .11) .90
= 18.20%
For investment IV, Rs = .11 + (.19 - .11) 1.50
= 23%
Comparison of dividend yield with the expected return Rs shows that the dividend yields of
investment I, II and III are less than the corresponding Rs,. So, these investments are over-
priced and should be sold by the investor. However, in case of investment IV, the dividend
yield is more than the corresponding Rs, so, XYZ Ltd. should increase its proportion.
Question 33
A company has a choice of investments between several different equity oriented mutual
funds. The company has an amount of `1 crore to invest. The details of the mutual funds are
as follows:
Mutual Fund Beta
A 1.6
B 1.0
C 0.9

D 2.0
E 0.6
Required:
(i) If the company invests 20% of its investment in each of the first two mutual funds and an
equal amount in the mutual funds C, D and E, what is the beta of the portfolio?
(ii) If the company invests 15% of its investment in C, 15% in A, 10% in E and the balance in
equal amount in the other two mutual funds, what is the beta of the portfolio?
(iii) If the expected return of market portfolio is 12% at a beta factor of 1.0, what will be the
portfolios expected return in both the situations given above?
Answer
With 20% investment in each MF Portfolio Beta is the weighted average of the Betas of
various securities calculated as below:
(i)
Investment Beta (β) Investment Weighted
(` Lacs) Investment
A 1.6 20 32
B 1.0 20 20
C 0.9 20 18
D 2.0 20 40
E 0.6 20 12
100 122
Weighted Beta (β) = 1.22
(ii) With varied percentages of investments portfolio beta is calculated as follows:
Investment Beta (β) Investment Weighted
(` Lacs) Investment
A 1.6 15 24
B 1.0 30 30
C 0.9 15 13.5
D 2.0 30 60
E 0.6 10 6
100 133.5
Weighted Beta (β) = 1.335

(iii) Expected return of the portfolio with pattern of investment as in case (i)
= 12% × 1.22 i.e. 14.64%
Expected Return with pattern of investment as in case (ii) = 12% × 1.335 i.e., 16.02%.
Question 34
Suppose that economy A is growing rapidly and you are managing a global equity fund and so
far you have invested only in developed-country stocks only. Now you have decided to add
stocks of economy A to your portfolio. The table below shows the expected rates of return,
standard deviations, and correlation coefficients (all estimates are for aggregate stock market
of developed countries and stock market of Economy A).
Developed Country Stocks of
Stocks Economy A
Expected rate of return (annualized 10 15
percentage)
Risk [Annualized Standard Deviation (%)] 16 30
Correlation Coefficient (ρ ) 0.30
Assuming the risk-free interest rate to be 3%, you are required to determine:
(a) What percentage of your portfolio should you allocate to stocks of Economy A if you want
to increase the expected rate of return on your portfolio by 0.5%?
(b) What will be the standard deviation of your portfolio assuming that stocks of Economy A
are included in the portfolio as calculated above?
(c) Also show how well the Fund will be compensated for the risk undertaken due to
inclusion of stocks of Economy A in the portfolio?
Answer
(a) Let the weight of stocks of Economy A is expressed as w, then
(1- w)×10.0 + w ×15.0 = 10.5
i.e. w = 0.1 or 10%.
(b) Variance of portfolio shall be:
(0.9)2 (0.16) 2 + (0.1)2 (0.30) 2+ 2(0.9) (0.1) (0.16) (0.30) (0.30) = 0.02423
Standard deviation is (0.02423)½= 0.15565 or 15.6%.
(c) The Sharpe ratio will improve by approximately 0.04, as shown below:
Expected Return - Risk Free Rate of Return
Sharpe Ratio =
Standard Deviation

10 - 3
Investment only in developed countries: = 0.437
16
10.5 - 3
With inclusion of stocks of Economy A: = 0.481
15.6
Question 35
Mr. FedUp wants to invest an amount of ` 520 lakhs and had approached his Portfolio
Manager. The Portfolio Manager had advised Mr. FedUp to invest in the following manner:
Security Moderate Better Good Very Good Best
Amount (in ` Lakhs) 60 80 100 120 160
Beta 0.5 1.00 0.80 1.20 1.50
You are required to advise Mr. FedUp in regard to the following, using Capital Asset Pricing
Methodology:
(i) Expected return on the portfolio, if the Government Securities are at 8% and the NIFTY is
yielding 10%.
(ii) Advisability of replacing Security 'Better' with NIFTY.
Answer
(i) Computation of Expected Return from Portfolio
Security Beta Expected Return (r) Amount Weights wr
(β) as per CAPM (` Lakhs) (w)
Moderate 0.50 8%+0.50(10% - 8%) = 9% 60 0.115 1.035
Better 1.00 8%+1.00(10% - 8%) = 10% 80 0.154 1.540
Good 0.80 8%+0.80(10% - 8%) = 9.60% 100 0.192 1.843
Very Good 1.20 8%+1.20(10% - 8%) = 10.40% 120 0.231 2.402
Best 1.50 8%+1.50(10% - 8%) = 11% 160 0.308 3.388
Total 520 1 10.208
Thus Expected Return from Portfolio 10.208% say 10.21%.

Alternatively, it can be computed as follows:
60 80 100 120 160
Average β = 0.50 x + 1.00 x + 0.80 x + 1.20 x + 1.50 x = 1.104
520 520 520 520 520
As per CAPM
= 0.08 + 1.104(0.10 – 0.08) = 0.10208 i.e. 10.208%

(ii) As computed above the expected return from Better is 10% same as from Nifty, hence
there will be no difference even if the replacement of security is made. The main logic
behind this neutrality is that the beta of security ‘Better’ is 1 which clearly indicates that
this security shall yield same return as market return.
Question 36
Your client is holding the following securities:
Particulars of Securities Cost Dividends/Interest Market price Beta
` ` `
Equity Shares:
Gold Ltd. 10,000 1,725 9,800 0.6
Silver Ltd. 15,000 1,000 16,200 0.8
Bronze Ltd. 14,000 700 20,000 0.6
GOI Bonds 36,000 3,600 34,500 0.01
Average return of the portfolio is 15.7%, calculate:
(i) Expected rate of return in each, using the Capital Asset Pricing Model (CAPM).
(ii) Risk free rate of return.
Answer
Particulars of Securities Cost ` Dividend Capital gain
Gold Ltd. 10,000 1,725 −200
Silver Ltd. 15,000 1,000 1,200
Bronz Ltd. 14,000 700 6,000
GOI Bonds 36,000 3,600 −1,500
Total 75,000 7,025 5,500
Expected rate of return on market portfolio

Dividend Earned + Capital appreciation
× 100
Initial investment
` 7,025 + ` 5,500
= × 100 = 16.7%
` 75,000
Risk free return
0.6 + 0.8 + 0.6 + 0.01
Average of Betas = = Average of Betas* = 0.50
4

Average return = Risk free return + Average Betas (Expected return – Risk free return)
15.7 = Risk free return + 0.50 (16.7 – Risk free return)
Risk free return = 14.7%
* Alternatively, it can also be calculated through Weighted Average Beta.
Expected Rate of Return for each security is
Rate of Return = Rf + B (Rm – Rf)
Gold Ltd. = 14.7 + 0.6 (16.7 – 14.7) = 15.90%
Silver Ltd. = 14.7 + 0.8 (16.7 – 14.7) = 16.30%
Bronz Ltd. = 14.7 + 0.6 (16.7 – 14.7) = 15.90%
GOI Bonds = 14.7 + 0.01 (16.7 – 14.7) = 14.72%
* Alternatively, it can also be computed by using Weighted Average Method.
Question 37
A holds the following portfolio:
Share/Bond Beta Initial Price Dividends Market Price at end of year
` ` `
Epsilon Ltd. 0.8 25 2 50
Sigma Ltd. 0.7 35 2 60
Omega Ltd. 0.5 45 2 135
GOI Bonds 0.01 1,000 140 1,005
Calculate:
(i) The expected rate of return of each security using Capital Asset Pricing Method (CAPM)
(ii) The average return of his portfolio.
Risk-free return is 14%.
Answer
(i) Expected rate of return
Total Investments Dividends Capital Gains
Epsilon Ltd. 25 2 25
Sigma Ltd. 35 2 25
Omega Ltd. 45 2 90
GOI Bonds 1,000 140 _5
1,105 146 145

146 + 145
Expected Return on market portfolio= = 26.33%
1105
CAPM E(Rp) = RF + β [E(RM) – RF]
Epsilon Ltd 14+0.8 [26.33-14] = 14+9.86 = 23.86%
Sigma Ltd. 14+0.7 [26.33-14] = 14+8.63 = 22.63%
Omega Ltd. 14+0.5 [26.33-14] = 14+6.17 = 20.17%
GOI Bonds 14+0.01 [26.33-14] = 14+0.12 = 14.12%
(ii) Average Return of Portfolio
23.86 + 22.63 + 20.17 + 14.12 80.78
= = 20.20%
4 4
0.8 + 0.7 + 0.5 + 0.01 2.01
Alternatively = = 0.5025
4 4
14+0.5025 (26.33- 14) = 14+ 6.20 = 20.20%
Question 38
Your client is holding the following securities:
Particulars of Securities Cost Dividends Market Price BETA
` ` `
Equity Shares:
Co. X 8,000 800 8,200 0.8
Co. Y 10,000 800 10,500 0.7
Co. Z 16,000 800 22,000 0.5
PSU Bonds 34,000 3,400 32,300 0.2
Assuming a Risk-free rate of 15%, calculate:
– Expected rate of return of each security, using the Capital Asset Pricing Model (CAPM).
– Average return of the portfolio.
Answer
Calculation of expected return on market portfolio (Rm)
Investment Cost (`) Dividends (`) Capital Gains (`)
Shares X 8,000 800 200
Shares Y 10,000 800 500

Shares Z 16,000 800 6,000

PSU Bonds 34,000 3,400 –1,700
68,000 5,800 5,000
5,800 + 5,000
R = × 100 = 15.88%
m 68,000
Calculation of expected rate of return on individual security:
Security
Shares X 15 + 0.8 (15.88 – 15.0) = 15.70%
Shares Y 15 + 0.7 (15.88 – 15.0) = 15.62%
Shares Z 15 + 0.5 (15.88 – 15.0) = 15.44%
PSU Bonds 15 + 0.2 (15.88 – 15.0) = 15.18%
Calculation of the Average Return of the Portfolio:

15.70 + 15.62 + 15.44 + 15.18
= = 15.49%.
4
Question 39
An investor is holding 1,000 shares of Fatlass Company. Presently the rate of dividend being
paid by the company is ` 2 per share and the share is being sold at ` 25 per share in the
market. However, several factors are likely to change during the course of the year as
indicated below:
Existing Revised
Risk free rate 12% 10%
Market risk premium 6% 4%
Beta value 1.4 1.25
Expected growth rate 5% 9%
In view of the above factors whether the investor should buy, hold or sell the shares? And
why?
Answer
On the basis of existing and revised factors, rate of return and price of share is to be
calculated.
Existing rate of return
= Rf + Beta (Rm – Rf) = 12% + 1.4 (6%) = 20.4%

Revised rate of return

= 10% + 1.25 (4%) = 15%
Price of share (original)
D (1 + g) 2 (1.05) 2.10
Po = = = = Rs. 13.63
K e - g .204 - .05 .154
Price of share (Revised)

2 (1.09) 2.18
Po = = = Rs. 36.33
.15 - .09 .06
In case of existing market price of ` 25 per share, rate of return (20.4%) and possible
equilibrium price of share at ` 13.63, this share needs to be sold because the share is
overpriced (` 25 – 13.63) by ` 11.37. However, under the changed scenario where growth of
dividend has been revised at 9% and the return though decreased at 15% but the possible
price of share is to be at ` 36.33 and therefore, in order to expect price appreciation to `
36.33 the investor should hold the shares, if other things remain the same.
Question 40
An investor is holding 5,000 shares of X Ltd. Current year dividend rate is ` 3/ share. Market
price of the share is ` 40 each. The investor is concerned about several factors which are
likely to change during the next financial year as indicated below:
Current Year Next Year
Dividend paid /anticipated per share (`) 3 2.5
Risk free rate 12% 10%
Market Risk Premium 5% 4%
Beta Value 1.3 1.4
Expected growth 9% 7%
In view of the above, advise whether the investor should buy, hold or sell the shares.
Answer
On the basis of existing and revised factors, rate of return and price of share is to be
calculated.
Existing rate of return
= Rf + Beta (Rm – Rf)
= 12% + 1.3 (5%) = 18.5%

Revised rate of return

= 10% + 1.4 (4%) = 15.60%
Price of share (original)
D (1 + g) 3 (1.09) 3.27
P = = = = ` 34.42
o K -g 0.185 - 0.09 0.095
e
Price of share (Revised)

2.50 (1.07) 2.675
P = = = ` 31.10
o 0.156 - 0.07 0.086
Market price of share of ` 40 is higher in comparison to current equilibrium price of ` 34.42 and
revised equity price of ` 31.10. Under this situation investor should sell the share.
Question 41
An investor has two portfolios known to be on minimum variance set for a population of three
securities A, B and C having below mentioned weights:
WA WB WC
Portfolio X 0.30 0.40 0.30
Portfolio Y 0.20 0.50 0.30
It is supposed that there are no restrictions on short sales.
(i) What would be the weight for each stock for a portfolio constructed by investing ` 5,000
in portfolio X and ` 3,000 in portfolio Y?.
(ii) Suppose the investor invests ` 4,000 out of ` 8,000 in security A. How he will allocate
the balance between security B and C to ensure that his portfolio is on minimum variance
set?
Answer
(i) Investment committed to each security would be:-
A B C Total
(`) (`) (`) (`)
Portfolio X 1,500 2,000 1,500 5,000
Portfolio Y 600 1,500 900 3,000
Combined Portfolio 2,100 3,500 2,400 8,000
∴ Stock weights 0.26 0.44 0.30

(ii) The equation of critical line takes the following form:-

WB = a + bWA
Substituting the values of WA & WB from portfolio X and Y in above equation, we get
0.40 = a + 0.30b, and
0.50 = a + 0.20b
Solving above equation we obtain the slope and intercept, a = 0.70 and b= -1 and thus,
the critical line is
WB = 0.70 – WA
If half of the funds is invested in security A then,
WB = 0.70 – 0.50 = 0.20
Since WA + WB + WC = 1
WC = 1 - 0.50 – 0.20 = 0.30
∴ Allocation of funds to security B = 0.20 x 8,000 = ` 1,600, and
Security C = 0.30 x 8,000 = ` 2,400
Question 42
X Co., Ltd., invested on 1.4.2009 in certain equity shares as below:
Name of Co. No. of shares Cost (`)
M Ltd. 1,000 (` 100 each) 2,00,000
N Ltd. 500 (` 10 each) 1,50,000
In September, 2009, 10% dividend was paid out by M Ltd. and in October, 2009, 30% dividend
paid out by N Ltd. On 31.3.2010 market quotations showed a value of ` 220 and ` 290 per
share for M Ltd. and N Ltd. respectively.
On 1.4.2010, investment advisors indicate (a) that the dividends from M Ltd. and N Ltd. for the
year ending 31.3.2011 are likely to be 20% and 35%, respectively and (b) that the probabilities
of market quotations on 31.3.2011 are as below:
Probability factor Price/share of M Ltd. Price/share of N Ltd.
0.2 220 290
0.5 250 310
0.3 280 330
You are required to:
(i) Calculate the average return from the portfolio for the year ended 31.3.2010;

(ii) Calculate the expected average return from the portfolio for the year 2010-11; and
(iii) Advise X Co. Ltd., of the comparative risk in the two investments by calculating the
standard deviation in each case.
Answer
Calculation of return on portfolio for 2009-10 (Calculation in
` / share)
M N
Dividend received during the year 10 3
Capital gain/loss by 31.03.10
Market value by 31.03.10 220 290
Cost of investment 200 300
Gain/loss 20 (-)10
Yield 30 (-)7
Cost 200 300
% return 15% (-)2.33%
Weight in the portfolio 57 43
Weighted average return 7.55%
Calculation of estimated return for 2010-11
Expected dividend 20 3.5
Capital gain by 31.03.11
(220x0.2)+ (250x0.5)+(280x0.3) – 220=(253-220) 33 -
(290x0.2)+(310x0.5)+(330x0.3) – 290= (312 – 290) - 22
Yield 53 25.5
*Market Value 01.04.10 220 290
% return 24.09% 8.79%
*Weight in portfolio (1,000x220): (500x290) 60.3 39.7
Weighted average (Expected) return 18.02%
(*The market value on 31.03.10 is used as the base for
calculating yield for 10-11)

Calculation of Standard Deviation

M Ltd.
Exp. Exp. Exp. Exp Prob. (1) Dev. Square (2) X (3)
market gain div. Yield Factor X(2) (PM - of dev.
value (1) (2) PM ) (3)
220 0 20 20 0.2 4 -33 1089 217.80
250 30 20 50 0.5 25 -3 9 4.50
280 60 20 80 0.3 24 27 729 218.70
53 σ2M =
441.00
Standard Deviation (σM) 21

N Ltd.
Exp. Exp. Exp. Exp Prob. (1) Dev. Square (2) X (3)
market gain div. Yield Factor X(2) (PN- PN ) of dev.
value (1) (2) (3)
290 0 3.5 3.5 0.2 0.7 -22 484 96.80
310 20 3.5 23.5 0.5 11.75 -2 4 2.00
330 40 3.5 43.5 0.3 13.05 18 324 97.20
25.5 σ2N = 196.00
Standard Deviation (σN) 14
Share of company M Ltd. is more risky as the S.D. is more than company N Ltd.
Question 43
An investor holds two stocks A and B. An analyst prepared ex-ante probability distribution for
the possible economic scenarios and the conditional returns for two stocks and the market
index as shown below:
Economic scenario Probability Conditional Returns %
A B Market
Growth 0.40 25 20 18
Stagnation 0.30 10 15 13
Recession 0.30 -5 -8 -3

The risk free rate during the next year is expected to be around 11%. Determine whether the
investor should liquidate his holdings in stocks A and B or on the contrary make fresh
investments in them. CAPM assumptions are holding true.
Answer
Expected Return on stock A = E (A) = ∑ PA

i=G,S,R i i
(G,S & R, denotes Growth, Stagnation and Recession )
(0.40)(25) + 0.30(10)+ 0.30(-5) = 11.5%
Expected Return on ‘B’
(0.40×20) + (0.30×15) +0.30× (-8)=10.1%
Expected Return on Market index
(0.40 × 18) + (0.30 × 13) + 0.30 × (-3) =10.2%
Variance of Market index
(18 - 10.2)2 (0.40) + (13 - 10.2)2 (0.30) + (-3 - 10.2)2 (0.30)
= 24.34 + 2.35 + 52.27 = 78.96%
Covariance of stock A and Market Index M
Cov. (AM) = ∑ ([A - E(A)] [Mi - E(M)]Pi

i=G,S,R i
(25 -11.5) (18 - 10.2)(0.40) + (10 - 11.5) (13 - 10.2) (0.30) + (-5-11.5) (-3-10.2)(0.30)
= 42.12 + (-1.26) + 65.34=106.20
Covariance of stock B and Market index M
(20-10.1) (18-10.2)(0.40)+(15-10.1)(13-10.2)(0.30) + (-8-10.1)(-3-10.2)(0.30)= 30.89 + 4.12 +
71.67=106.68
CoV(AM) 106.20
Beta for stock A = = = 1.345
VAR(M) 78.96
CoV(BM) 106.68
Beta for Stock B = = =1.351
VarM 78.96
Required Return for A
R (A) = Rf + β (M-Rf)
11% + 1.345(10.2 - 11) % = 9.924%

Required Return for B

11% + 1.351 (10.2 – 11) % = 9.92%
Alpha for Stock A
E (A) – R (A) i.e. 11.5 % – 9.924% = 1.576%
Alpha for Stock B
E (B) – R (B) i.e. 10.1% - 9.92% = 0.18%
Since stock A and B both have positive Alpha, therefore, they are UNDERPRICED. The investor
should make fresh investment in them.
Question 44
Following are the details of a portfolio consisting of three shares:
Share Portfolio weight Beta Expected return in % Total variance
A 0.20 0.40 14 0.015
B 0.50 0.50 15 0.025
C 0.30 1.10 21 0.100
Standard Deviation of Market Portfolio Returns = 10%
You are given the following additional data:
Covariance (A, B) = 0.030
Covariance (A, C) = 0.020
Covariance (B, C) = 0.040
Calculate the following:
(i) The Portfolio Beta
(ii) Residual variance of each of the three shares
(iii) Portfolio variance using Sharpe Index Model
(iv) Portfolio variance (on the basis of modern portfolio theory given by Markowitz)
Answer
(i) Portfolio Beta
0.20 x 0.40 + 0.50 x 0.50 + 0.30 x 1.10 = 0.66
(ii) Residual Variance
To determine Residual Variance first of all we shall compute the Systematic Risk as
follows:

β2A × σ M
2
= (0.40)2(0.01) = 0.0016
βB2 × σ M
2
= (0.50)2(0.01) = 0.0025
β2C × σ M
2
= (1.10)2(0.01) = 0.0121
Residual Variance
A 0.015 – 0.0016 = 0.0134
B 0.025 – 0.0025 = 0.0225
C 0.100 – 0.0121 = 0.0879
(iii) Portfolio variance using Sharpe Index Model
Systematic Variance of Portfolio = (0.10)2 x (0.66)2 = 0.004356
Unsystematic Variance of Portfolio = 0.0134 x (0.20)2 + 0.0225 x (0.50)2 + 0.0879 x
(0.30)2 = 0.014072
Total Variance = 0.004356 + 0.014072 = 0.018428
(iii) Portfolio variance on the basis of Markowitz Theory
2 2
= (wA x wAx σ A ) + (wA x wBxCovAB) + (wA x wCxCovAC) + (wB x wAxCovAB) + (wB x wBx σ B )
2
+ (wB x wCxCovBC) + (wC x wAxCovCA) + (wC x wBxCovCB) + (wC x wCx σ c )
= (0.20 x 0.20 x 0.015) + (0.20 x 0.50 x 0.030) + (0.20 x 0.30 x 0.020) + (0.20 x 0.50 x
0.030) + (0.50 x 0.50 x 0.025) + (0.50 x 0.30 x 0.040) + (0.30 x 0.20 x 0.020) + (0.30 x
0.50 x 0.040) + (0.30 x 0.30 x 0.10)
= 0.0006 + 0.0030 + 0.0012 + 0.0030 + 0.00625 + 0.0060 + 0.0012 + 0.0060 + 0.0090
= 0.0363
Question 45
Ramesh wants to invest in stock market. He has got the following information about individual
securities:
Security Expected Return Beta σ2 ci
A 15 1.5 40
B 12 2 20
C 10 2.5 30
D 09 1 10
E 08 1.2 20
F 14 1.5 30

Market index variance is 10 percent and the risk free rate of return is 7%. What should be the
optimum portfolio assuming no short sales?
Answer
Securities need to be ranked on the basis of excess return to beta ratio from highest to the
lowest.
Security Ri βi Ri - Rf Ri - Rf
βi
A 15 1.5 8 5.33
B 12 2 5 2.5
C 10 2.5 3 1.2
D 9 1 2 2
E 8 1.2 1 0.83
F 14 1.5 7 4.67
Ranked Table:
(R i - R f ) x β i N
(R i - R f ) x β i β i2 N
β i2
Sec Ri - Rf
βi σ 2 ei
σ 2 ei
∑ σ 2 ei σ 2 ei
∑σ 2 Ci
urity e=i e=i ei
A 8 1.5 40 0.30 0.30 0.056 0.056 1.923

F 7 1.5 30 0.35 0.65 0.075 0.131 2.814
B 5 2 20 0.50 1.15 0.20 0.331 2.668
D 2 1 10 0.20 1.35 0.10 0.431 2.542
C 3 2.5 30 0.25 1.60 0.208 0.639 2.165
E 1 1.2 20 0.06 1.66 0.072 0.711 2.047
CA = 10 x 0.30 / [1 + ( 10 x 0.056)] = 1.923
CF = 10 x 0.65 / [1 + ( 10 x 0.131)] = 2.814
CB = 10 x 1.15 / [1 + ( 10 x 0.331)] = 2.668
CD = 10 x 1.35 / [1 + ( 10 x 0.431)] = 2.542
CC = 10 x 1.60 / [1 + ( 10 x 0.639)] = 2.165
CE = 10 x 1.66 / [1 + ( 10 x 0.7111)] = 2.047
Cut off point is 2.814

Z = i 
(
β   R - R
[ i f
) - C] 
i 2 
σ ei 
 β  
 i 
1.5
ZA = ( 5.33 - 2.814) = 0.09435
40
1.5
Z = ( 4.67 - 2.814) = 0.0928
F 30
XA = 0.09435 / [ 0.09435 + 0.0928] = 50.41%
XF = 0.0928 / [0.09435 + 0.0928] = 49.59%
Funds to be invested in security A & F are 50.41% and 49.59% respectively.

Question 46
A Portfolio Manager (PM) has the following four stocks in his portfolio:
Security No. of Shares Market Price per share (`) β
VSL 10,000 50 0.9
CSL 5,000 20 1.0
SML 8,000 25 1.5
APL 2,000 200 1.2
Compute the following:
(i) Portfolio beta.
(ii) If the PM seeks to reduce the beta to 0.8, how much risk free investment should he bring in?
(iii) If the PM seeks to increase the beta to 1.2, how much risk free investment should he
bring in?
Answer
Security No. of Market Price of (1) × (2) % to total ß (x) wx
shares Per Share (2) (w)
(1)
VSL 10000 50 500000 0.4167 0.9 0.375
CSL 5000 20 100000 0.0833 1 0.083
SML 8000 25 200000 0.1667 1.5 0.250

APL 2000 200 400000 0.3333 1.2 0.400

1200000 1 1.108
Portfolio beta 1.108
(i) Required Beta 0.8
It should become (0.8 / 1.108) 72.2 % of present portfolio
If ` 12,00,000 is 72.20%, the total portfolio should be
` 12,00,000 × 100/72.20 or ` 16,62,050
Additional investment in zero risk should be (` 16,62,050 – ` 12,00,000) = ` 4,62,050
Revised Portfolio will be
Security No. of Market Price (1) × (2) % to ß (x) wx
shares of Per Share total
(1) (2) (w)
VSL 10000 50 500000 0.3008 0.9 0.271
CSL 5000 20 100000 0.0602 1 0.060
SML 8000 25 200000 0.1203 1.5 0.180
APL 2000 200 400000 0.2407 1.2 0.289
Risk free asset 46205 10 462050 0.2780 0 0
1662050 1 0.800
(ii) To increase Beta to 1.2

Required beta 1.2
It should become 1.2 / 1.108 108.30% of present beta
If 1200000 is 108.30%, the total portfolio should be
1200000 × 100/108.30 or 1108033 say 1108030
Additional investment should be (-) 91967 i.e. Divest ` 91970 of Risk Free Asset
Revised Portfolio will be
Security No. of Market Price (1) × (2) % to total ß (x) wx
shares of Per Share (w)
(1) (2)
VSL 10000 50 500000 0.4513 0.9 0.406
CSL 5000 20 100000 0.0903 1 0.090
SML 8000 25 200000 0.1805 1.5 0.271

APL 2000 200 400000 0.3610 1.2 0.433

Risk free asset -9197 10 -91970 -0.0830 0 0
1108030 1 1.20
Portfolio beta 1.20
Question 47
A has portfolio having following features:
Security β Random Error σei Weight
L 1.60 7 0.25
M 1.15 11 0.30
N 1.40 3 0.25
K 1.00 9 0.20
You are required to find out the risk of the portfolio if the standard deviation of the market
index (σm) is 18%.
Answer
4
βp = ∑xβ
i=1
i i
= 1.60 x 0.25 + 1.15 x 0.30 + 1.40 x 0.25 + 1.00 x 0.20

= 0.4 + 0.345 + 0.35 + 0.20 = 1.295
The Standard Deviation (Risk) of the portfolio is
= [(1.295)2(18)2+(0.25)2(7)2+(0.30)2(11)2+(0.25)2(3)2+(0.20)2(9)2)]
= [543.36 + 3.0625 + 10.89 + 0.5625 + 3.24] = [561.115] ½ = 23.69%
Alternative Answer
The variance of Security’s Return
σ2 = β i2 σ2m + σ2εi
Accordingly, variance of various securities
σ2 Weight(w) σ2Xw
L (1.60)2 (18)2 + 72 = 878.44 0.25 219.61
M (1.15)2 (18)2 + 112 = 549.49 0.30 164.85
N (1.40)2 (18)2 + 32 = 644.04 0.25 161.01

K (1.00)2 (18)2 + 92 = 405.00 0.20 81

Variance 626.47
SD = 626.47 = 25.03
Question 48
Mr. Tamarind intends to invest in equity shares of a company the value of which depends
upon various parameters as mentioned below:
Factor Beta Expected value Actual value in %
in%
GNP 1.20 7.70 7.70
Inflation 1.75 5.50 7.00
Interest rate 1.30 7.75 9.00
Stock market index 1.70 10.00 12.00
Industrial production 1.00 7.00 7.50
If the risk free rate of interest be 9.25%, how much is the return of the share under Arbitrage
Pricing Theory?
Answer
Return of the stock under APT
Factor Actual Expected Difference Beta Diff. х
value in % value in % Beta
GNP 7.70 7.70 0.00 1.20 0.00
Inflation 7.00 5.50 1.50 1.75 2.63
Interest rate 9.00 7.75 1.25 1.30 1.63
Stock index 12.00 10.00 2.00 1.70 3.40
Ind. Production 7.50 7.00 0.50 1.00 0.50
8.16
Risk free rate in % 9.25
Return under APT 17.41
Question 49
The total market value of the equity share of O.R.E. Company is ` 60,00,000 and the total
value of the debt is ` 40,00,000. The treasurer estimate that the beta of the stock is currently
1.5 and that the expected risk premium on the market is 10 per cent. The treasury bill rate is 8
per cent.

Required:
(1) What is the beta of the Company’s existing portfolio of assets?
(2) Estimate the Company’s Cost of capital and the discount rate for an expansion of the
company’s present business.
Answer
V V
(1) β company = β equity × E + Bdebt × D
V0 V0
Note: Since β debt is not given it is assumed that company debt capital is virtually riskless.
If company’s debt capital is riskless than above relationship become:
VE
Here β equity = 1.5; β company = β equity
V0
As β debt = 0
VE = ` 60 lakhs.
VD = ` 40 lakhs.
V0 = ` 100 lakhs.
` 60 lakhs
βcompany assets= 1.5 ×
` 100 lakhs
= 0.9
(2) Company’s cost of equity = Rf + β A × Risk premium
Where Rf = Risk free rate of return
β A = Beta of company assets
Therefore, company’s cost of equity = 8% + 0.9 × 10 = 17% and overall cost of capital
shall be
60,00,000 40,00,000
= 17%× +8%×
100,00,000 100,00,000
= 10.20% + 3.20% = 13.40%
Alternatively it can also be computed as follows:
Cost of Equity = 8% + 1.5 x 10 = 23%
Cost of Debt = 8%
60,00,000 40,00,000
WACC (Cost of Capital) = 23% × + 8% × = 17%
1,00,00,000 1,00,00,000

In case of expansion of the company’s present business, the same rate of return i.e.
13.40% will be used. However, in case of diversification into new business the risk profile
of new business is likely to be different. Therefore, different discount factor has to be
worked out for such business.
Question 50
Mr. Nirmal Kumar has categorized all the available stock in the market into the following types:
(i) Small cap growth stocks
(ii) Small cap value stocks
(iii) Large cap growth stocks
(iv) Large cap value stocks
Mr. Nirmal Kumar also estimated the weights of the above categories of stocks in the market
index. Further, the sensitivity of returns on these categories of stocks to the three important
factor are estimated to be:
Category of Weight in the Factor I (Beta) Factor II (Book Factor III
Stocks Market Index Price) (Inflation)
Small cap growth 25% 0.80 1.39 1.35
Small cap value 10% 0.90 0.75 1.25
Large cap growth 50% 1.165 2.75 8.65
Large cap value 15% 0.85 2.05 6.75
Risk Premium 6.85% -3.5% 0.65%
The rate of return on treasury bonds is 4.5%
Required:
(a) Using Arbitrage Pricing Theory, determine the expected return on the market index.
(b) Using Capital Asset Pricing Model (CAPM), determine the expected return on the market
index.
(c) Mr. Nirmal Kumar wants to construct a portfolio constituting only the ‘small cap value’
and ‘large cap growth’ stocks. If the target beta for the desired portfolio is 1, determine
the composition of his portfolio.
Answer
(a) Method I
Stock’s return
Small cap growth = 4.5 + 0.80 x 6.85 + 1.39 x (-3.5) + 1.35 x 0.65 = 5.9925%
Small cap value = 4.5 + 0.90 x 6.85 + 0.75 x (-3.5) + 1.25 x 0.65 = 8.8525%

Large cap growth = 4.5 + 1.165 x 6.85 + 2.75 x (-3.5) + 8.65 x 0.65 = 8.478%
Large cap value = 4.5 + 0.85 x 6.85 + 2.05 x (-3.5) + 6.75 x 0.65 = 7.535%
Expected return on market index
0.25 x 5.9925 + 0.10 x 8.8525 + 0.50 x 8.478 + 0.15 x 7.535 = 7.7526%
Method II
Expected return on the market index
= 4.5% + [0.1x0.9 + 0.25x0.8 + 0.15x0.85 + 0.50x1.165] x 6.85 + [(0.75 x 0.10 + 1.39
x 0.25 + 2.05 x 0.15 + 2.75 x 0.5)] x (-3.5) + [{1.25 x 0.10 + 1.35 x 0.25 + 6.75 x
0.15 + 8.65 x 0.50)] x 0.65
= 4.5 + 6.85 + (-7.3675) + 3.77 = 7.7525%.
(b) Using CAPM,
Small cap growth = 4.5 + 6.85 x 0.80 = 9.98%
Small cap value = 4.5 + 6.85 x 0.90 = 10.665%
Large cap growth = 4.5 + 6.85 x 1.165 = 12.48%
Large cap value = 4.5 + 6.85 x 0.85 = 10.3225%
Expected return on market index
= 0.25 x 9.98 + 0.10 x 10.665 + 0.50 x 12.45 + 0.15 x 10.3225 = 11.33%
(c) Let us assume that Mr. Nirmal will invest X1% in small cap value stock and X2% in large
cap growth stock
X1 + X2 = 1
0.90 X1 + 1.165 X2 = 1
0.90 X1 + 1.165(1 – X1) = 1
0.90 X1 + 1.165 – 1.165 X1 = 1
0.165 = 0.265 X1
0.165
= X1
0.265
0.623 = X1, X2 = 0.377
62.3% in small cap value
37.7% in large cap growth.

Question 51
The following are the data on five mutual funds:
Fund Return Standard Deviation Beta
A 15 7 1.25
B 18 10 0.75
C 14 5 1.40
D 12 6 0.98
E 16 9 1.50
You are required to compute Reward to Volatility Ratio and rank these portfolio using:
♦ Sharpe method and
♦ Treynor's method
assuming the risk free rate is 6%.
Answer
Sharpe Ratio S = (Rp – Rf)/σp
Treynor Ratio T = (Rp – Rf)/βp
Where,
Rp = Return on Fund
Rf = Risk-free rate
σp = Standard deviation of Fund
βp = Beta of Fund
Reward to Variability (Sharpe Ratio)
Mutual Rp Rf Rp – Rf σp Reward to Ranking
Fund Variability
A 15 6 9 7 1.285 2
B 18 6 12 10 1.20 3
C 14 6 8 5 1.60 1
D 12 6 6 6 1.00 5
E 16 6 10 9 1.11 4
Reward to Volatility (Treynor Ratio)
Mutual Fund Rp Rf Rp – Rf βp Reward to Volatility Ranking
A 15 6 9 1.25 7.2 2
B 18 6 12 0.75 16 1
C 14 6 8 1.40 5.71 5
D 12 6 6 0.98 6.12 4
E 16 6 10 1.50 6.67 3

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7

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

(iii) Investors have identical time horizon;

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

Expected return X = 7.083 per

© The Institute of Chartered Accountants of India

Calculation of Standard Deviation of Returns

© The Institute of Chartered Accountants of India

Normal 0.50 ` 112 ` 100 ` 12

© The Institute of Chartered Accountants of India

Two asset portfolio

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

(v) Portfolio Risk

= (0.4 )2 (3)2 + (0.6)2 (3)2 + 2(0.4 )(0.6)(3)(3)(1)

© The Institute of Chartered Accountants of India

(ii) The average values for A and C for a proportion of 3 : 1 will be :

or (0.75)2 ×(4)2 +(0.25)2 ×(12)2 +2×0.75×0.25×4×12×1 = 6%

Year R1 Deviation Deviation R2 Deviation Deviation Product

© The Institute of Chartered Accountants of India

5 16 1.2 1.44 15 -6 36 -7.2

© The Institute of Chartered Accountants of India

(10 × 2398) - (148) 2 23980 - 21904

Standard deviation of security 2:

(10 × 4494) − (210) 2 44940− 44100

© The Institute of Chartered Accountants of India

Probability ABC(%) XYZ(%)

(1) (2) (3) (4) (5) (6)

© The Institute of Chartered Accountants of India

σX = Std. Deviation of XYZ

% ABC = 46%, XYZ = 54%

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

Year Krishna Ltd. (X) Market Index (Y) XY Y2

© The Institute of Chartered Accountants of India

STDEV σ f = 141 = 11.87

© The Institute of Chartered Accountants of India

Year Return % (Ra) Market return Deviation Deviation D Ra × Rm 2

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

Return Return xy x2 (x- x) (x- x) 2 (y- y ) (y- y ) 2

Unsystematic Risk is = Total Risk – Systematic Risk

© The Institute of Chartered Accountants of India

Period Return of Security X (%) Return on Market Portfolio (%)

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

Characteristic line for security X = α + β × RM

© The Institute of Chartered Accountants of India

For Defensive Stock

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

= 0.45x0.0884+ 0.35X0.1657+ 1.15X0.2486+ 1.85X0.4972 = 0.0398+ 0.058 + 0.2859 +

MFX MFY Mix

© The Institute of Chartered Accountants of India

Accordingly, for MFX